Brave new monetary policy – Ireland and Europe

Friday, January, 2011

Students of economics could do worse than read the recent speech by Lorenzo Bini Smaghi on the lessons for monetary policy from the recent crisis (19 Jan 2011).  Smaghi is a high profile member of the Executive Board of the ECB and readers may recall that he recently gave an interview to The Irish Times (15 Jan 2011) asserting that ‘Ireland’s meltdown is the outcome of the policies of its elected politicians’.

Up until the eruption of the global financial and economic crisis in the latter half of 2007, central bankers and their advisers tended to walk tall and proudly in the belief that they had at last conquered inflation and thereby solved the ills of the macroeconomy.  They tended to exhibit a certain swagger, on the verge of arrogance, that they had perfected a system of fine-tuning interest rates in response to price data and proudly proclaimed their victories in the form of keeping inflation within tightly-defined targets.  The main weapon in their armoury against inflation was, and continues to be, central bank independence.

I remember once a former colleague of mine at the University of Liverpool once pinned a graph to the door of his room showing an almost perfect-looking non-linear relationship between the rate of inflation, on the y-axis, and an index of the degree of central bank independence, on the x-axis, for a sample of developed countries.  A great teaching tool and illustration, it would have seemed, of the merits of central bank independence.  (As an aside, it showed that academics can and do care about their students.)

Looking back with the benefit of hindsight, it appears that the independent central bankers and their well-intentioned advisers, all perfectly laudable in principle, over-emphasised the battle with inflation and their fine-tuning monetary policy weapons.  With their focus on the macroeconomic problem of inflation, what they missed was the more subtle microeconomic issue of credit institutions’ incentives and how best to monitor and supervise them.  It’s was akin to having a referee on the pitch without any linesmen.  There will always be players looking to handle the ball or throw it into the net if they can get away with it, but it is the job of the referee and his assistants to policy the field.  And so it is with banking – banks’ incentives are basically to lend as much as possible and boost their profits but this needs to be properly watched by the presence of a strong financial referee.

According to Smaghi, the conventional wisdom prevailing before the crisis was that any exuberance in financial markets would not be “policy-relevant” unless it exerted upward pressures on the number one enemy – inflation.  Accordingly, central banks deemed that it would only be necessary to pick up the pieces after a price bubble had burst, and the costs of doing this relative to a policy of resisting the bubble while it is forming would not be large.

How wrong this strategy has proven to be.  As Smaghi observes, inflation and financial exuberance are often negatively – not positively – correlated, so that concentrating a central bank on inflation only means biasing the assessment of the risks to the macro-economy from a longer-term perspective.  Further, cleaning up the economy in the wake of a financial collapse can be exceedingly costly.  This raises the question of whether central banks should be given the task of ensuring both price stability and financial stability, and possibly given additional tools to do so.

In the wake of the events that have unfolded in Ireland and across the world, the answer to both these questions must be in the affirmative.  The key challenge is to ensure that macro-prudential and micro-prudential policies complement each other in a mutually consistent manner.  This is a complex area at the frontier of modern economics but Smaghi summarises it well: “macro-prudential supervision aims at limiting the likelihood of failure of significant portions of the financial system, or systemic risk. It follows that the macro-prudential supervision stresses the possibility that actions that may seem desirable or reasonable from the perspective of individual institutions may result in unwelcome system outcomes. Micro-prudential supervision, instead, aims at limiting the likelihood of failure of individual institutions. While the two policies have clearly a different scope, ultimately the micro-prudential sphere provides the instruments that can be activated in response to macro-prudential risks”.

The good news, I think, from Ireland’s perspective is that the new central bank commission structure is designed with both the macro-prudential and the micro-prudential dimensions of monetary policy in place – with Professor Patrick Honohan, a world-class monetary economist, and Matthew Elderfield, an experienced and independent financial regulator from another jurisdiction, assigned to the two aspects respectively.  The new commission is building its team and expertise in both regards.

The same re-building process is also taking place within the ECB, where the issues are even more complex because they involve both national and pan-national dimensions cutting across both the micro and macro dimensions of monetary policy.

As Smaghi notes, some progress at ECB level has been achieved with the creation of the three European supervisory authorities (for banking, markets and insurance) and the European Systemic Risk Board, which comprises the central banks and the three European agencies. The ESRB will be able to make recommendations, while implementation remains the responsibility of the national authorities.

What does all this mean for the person on the street?  Expect continuation of the fine-tuning battle against inflation (i.e. announcements about interest rates in response to macroeconomic developments such as growth and price data) plus (now and hopefully) more emphasis on effective supervision and regulation at the micro-level to mitigate the risk of price bubbles emerging.  What the brave new monetary policy will not be able to control are the (Keynes-coined) “animal spirits” of you and I – but that is another day’s work.

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